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Using data from the Bureau of Labor Statistics for the Consumer Price Index (CPI), students explore the latest release for December 2014. Building on last month's lesson that discusses the problems with the CPI, they learn about alternative ways of measuring inflation.

Current Key Economic Indicators

The Consumer Price Index for All Urban Consumers (CPI-U) declined 0.4% in December on a seasonally adjusted basis. The gasoline index fell 9.4% and was the main cause of the decrease in the seasonally adjusted all items index. The all items index increased 0.8% over the last 12 months, although the core inflation rate (less food and energy) did not change in December.

The unemployment rate rose to 5.7% in January of 2015, according to the Bureau of Labor Statistics release of Feb. 6, 2015. Total nonfarm employment rose by 257,000. Job gains were particularly strong in retail trade, construction, health care, financial activities, and manufacturing.This is the second month in a row that posted gains in construction and manufacturing.

Real GDP increased 2.6% in the fourth quarter of 2014, according to the advance estimate released by the Bureau of Economic Analysis. Consumer spending drove growth due to the reduction in gas prices, while a decrease in government expenditures was the most significant drag on growth. Third quarter growth was 5%.

In its January 28, 2015, statement, the FOMC cited the continued growth of the labor market, increased household and business spending, and below-target inflation as indicators of an economy that continues to recover. They expect below-target inflation to rise as oil prices and other "transitory" effects diminish. The statement reaffirmed the FOMC intention to keep the federal funds rate at its current low level. Notably, the FOMC added international variables to its list of factors to monitor for the timing of a rate increase.

INTRODUCTION

Every month, the Bureau of Labor Statistics releases the "Consumer Price Index Summary", a comprehensive report on the CPI and inflation rate. Each report provides the current estimates of price level changes for various categories of goods and services, as well as for major metropolitan areas.

This lesson uses the January 16, 2015, release for December 2014, to explore the relative changes by category, and the alternative ways that inflation can be measured.

Whose Buying Habits Does the CPI Reflect?: This page explains that the BLS measurement of the CPI-U includes all urban consumers, representing about 87 percent of the total U.S. population.
[EEL-link id='2255' title='bls.gov/cpi/cpifaq.htm#Question_3' ]

Consumer Price Index for all Urban Consumers: U.S. City Average, by Expenditure Category and Commodity and Service Group. This table explains the current level of the CPI-U.www.bls.gov/news.release/cpi.t01.htm

BLS Feature: Focus on Prices and Spending- What Does the Producer Price Index Measure? The BLS breaks down the official definition of the Producer Price Index to clear up common misconceptions about prices, production, and price pass-through within the PPI.www.bls.gov/ppi/

PROCESS

Refer students to the latest Bureau of Labor Statistics report on inflation for December 2014

Ask students what the change in the CPI was for the month of December 2014 (it decreased 0.4%). What was the main cause of this change? (gasoline prices fell significantly, as did fuel oil). What was the 12-month change? (0.8% increase) What was the previous 12-month period change that ended in November? (1.3% increase).

For the 12 month period ending in December 2014, how much have gas prices fallen? (21%) How much have used car and truck prices fallen? (4.2%). Ask students why they think used vehicle prices have fallen (answers may vary but should include strong new car sales because of the improvement in the economy and increased consumer confidence. Strong new car sales means lower used car sales, lowering the price).

Remind students that one of the problems with measuring inflation with the CPI is that it uses a fixed basket of consumer goods (see Focus on Data lesson from previous month). With the CPI, the quantity of goods and services remains the same, and the price changes--which is what is captured.

Tell students to assume that a virus has spread throughout the nation's chicken population (a chicken pox!), killing a lot of the chickens. Ask students what would happen to the price of chicken and eggs (the prices would go up). Ask students what consumers would do instead (they would probably start buying more beef). Ask students what would happen to the CPI in this case (the CPI would show a very big increase because it would assume that people would still consume the same amount of chicken and eggs, just at the (much) higher price). Ask students if they think that the CPI is an accurate measure of overall inflation in this case (answers may vary, but they will probably say that it does not).

Remind students that this failure to take into account substitutions that consumers make because of changes in price or other characteristics is one of the main problems with the CPI.

Tell students that there are other ways to measure the level of inflation in an economy besides the CPI. Ask students what measure is typically used to measure the health of an economy (answers may vary but should include the GDP).

Ask students what the components of GDP are (consumption, investment, government expenditures, net exports). Ask students if there is more than one measure of GDP (GDP is measured as real or nominal). Ask students what the difference is (nominal GDP is the value of output measured with current dollars; real GDP is the value of output measured in constant dollars--i.e., with the effect of price changes removed).

Tell students that there is a way to use nominal and real GDP to isolate the price change--calculating the GDP deflator:

GDP deflator = ( Nominal GDP/Real GDP) x 100

The GDP deflator does not measure the same thing as the CPI. While the CPI assumes a fixed basket of consumer goods, the GDP deflator includes other sectors in the economy, measuring inflation that all the economic agents face, not just consumers.

Return to the chicken example above. The problem with the CPI in this example is that it doesn't take into account the substitution that people would make away from chicken to beef. The GDP deflator, on the other hand, would pick up on that substitution, but as a result, would reflect no price change (if no one continued buying chicken) because the market basket would now not include chicken at all.

Tell students that the CPI assumes that there will be zero substitution. The GDP deflator assumes that there will be infinite substitution. Ask students if the GDP deflator is a better measure of inflation than the CPI (answers will vary but discussion should include how realistic each of the assumptions is).

Ask students which measure would tend to underestimate inflation (GDP deflator) and which would tend to overestimate (CPI).

Ask students if they can recall some of the other problems with the CPI (answers will vary but should include that the CPI doesn't take into account the change in quality of goods).

Remind students of the example used to illustrate this in last month's lesson--the new iPhone. Compared to the old iPhone, the new version has a bigger screen, better resolution, more batter life, etc. Tell students to assume that the old version is produced in the base year. Further, tell them to assume that the old version's overall quality can be thought of as one unit of quality. If the GDP deflator is 200, then the current price of the new version is twice as much as the old version--inflation. If the GDP deflator is 50, then the price of the new version is half as much as the old version--deflation.

Tell students to assume that the price of the old phone and the new one is the same, but that the quality of the new phone is twice what that of the old phone. In other words, the number of "quality" units would double. If the "quality" unit doubles and the price stays the same, the deflator would be 50, so it looks like the price level has fallen when it has really stayed the same and the quality of the product has changed.

Tell students to look at the following graph:

Ask students what they notice about the graph (by and large, the GDP deflator and the CPI are close, but the CPI is usually slightly more than the GDP deflator; there are a few instances where the CPI is much larger than the GDP deflator). Remind students that the CPI will tend to overestimate inflation while the GDP deflator will tend to underestimate, and the graph reflects that difference.

Call students' attention to the net exports component of GDP. Ask students what happens to GDP if we import more than we export, with everything else held the same (GDP decreases). Point out the significant differences between the CPI and the GDP deflator that occured in 2008 and 2011.

Tell students that the price of crude oil increased sharply in both of these years. Ask what effect that would have on the CPI (it would increase). Ask what effect it would have on the GDP deflator (they will probably say that it will also increase). Remind students that most of the crude oil in these years was imported, so both price and quantity enter into GDP calculations as a negative. So the import component of the GDP deflator could actually decrease during these periods, making the overall measure increase less.

ASSESSMENT ACTIVITY

CONCLUSION

Using the Consumer Price Index to measure inflation creates several problems. One alternative measure of the CPI is the GDP deflator, a broader-based measure of inflation among all the economy's agents. The GDP deflator addresses two of the shortcomings of the CPI--the CPI's assumption of no substitutions and the failure to account for goods' and services' quality changes. While the CPI tends to overstate inflation, the GDP deflator tends to understate it.

EXTENSION ACTIVITY

Ask students what they would expect to see with the CPI and GDP deflator if the price of crude oil fell drastically (the CPI would fall and the GDP deflator would increase, possibly even surpassing the CPI).